Preparing for the Next Recession: Six Things You Need to Know
By Jared Franz
Capital Group Economist
By Darrell Spence
Capital Group Economist
Recessions can be complicated, misunderstood and sometimes downright scary. With the U.S. expansion nearly 10 years old, investors may be wondering whether the next one is just around the corner.
In our view, we don’t believe a recession is imminent in 2019. Our research indicates it is much more likely that the next recession will be in 2020 or 2021. Regardless of the timing, it’s understandable if the idea of an eventual downturn is unsettling. But an analysis of the past 10 recessions suggests that economic pullbacks may not be as bad as people might fear. In this piece, we attempt to answer these common questions:
- What is a recession?
- What causes recessions?
- How long do recessions last?
- What happens to the stock market during a recession?
- What economic indicators can warn of a recession?
- How close are we to the next recession?
1. What is a recession?
Recessions are commonly defined as at least two consecutive quarters of declining GDP after a period of growth. More formally, the National Bureau of Economic Research (NBER) defines a recession as "a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real gross domestic product (GDP), real income, employment, industrial production and wholesale-retail sales." In this guide, we will use NBER’s official dates.
2. What causes recessions?
Past recessions have occurred for many reasons, but typically are the result of imbalances that build up in the economy and ultimately need to be corrected. For example, the 2008 recession was caused by excess debt in the housing market, whereas the 2001 contraction was caused by an asset bubble in technology stocks.
Although every cycle is unique, some common causes of recessions include rising interest rates, inflation and commodity prices. Anything that broadly hurts corporate profitability enough to trigger job reductions also can be responsible.
When unemployment rises, consumers typically reduce spending, which further pressures economic growth, company earnings and stock prices. These factors can fuel a vicious negative cycle that topples an economy.
3. How long do recessions last?
The good news is that recessions generally aren’t very long. Our analysis of 10 cycles since 1950 shows that recessions have lasted between eight and 18 months, with the average spanning about 11 months. For those directly affected by job loss or business closures, that can feel like an eternity. But investors with a long-term investment horizon would be better served looking at the full picture.
Recessions are relatively small blips in economic history. Over the last 65 years, the U.S. has been in an official recession less than 15% of all months. Moreover, the net economic impact of most recessions is relatively small. The average expansion increased economic output by 24%, whereas the average recession reduced GDP by less than 2%. Equity returns can even be positive over the full length of a contraction, since some of the strongest stock rallies have occurred during the late stages of a recession.
4. What happens to the stock market during a recession?
Even if a recession does not appear to be imminent, it’s never too early to think about how one could affect your portfolio. That’s because bear markets and recessions usually overlap at times — with equities leading the economic cycle by six to seven months on the way down and again on the way up.
During a recession, the stock market typically continues to decline sharply for several months. It then often bottoms out about six months after the start of a recession, and usually begins to rally before the economy starts humming again. (Keep in mind, these are market averages and can vary widely between cycles.)
Aggressive market-timing moves, such as shifting an entire portfolio into cash, can backfire. Some of the strongest returns can occur during the late stages of an economic cycle or immediately after a market bottom. It’s often better to stay invested to avoid missing out on the upswing.
5. What economic indicators can warn of a recession?
Wouldn’t it be great to know ahead of time when a recession is coming? Despite the impossibility of pinpointing the exact start of a recession, there are some generally reliable signals worth watching closely in a late-cycle economy.
Many factors can contribute to a recession, and the main causes often change. Therefore, it’s helpful to look at several different aspects of the economy to better gauge where excesses and imbalances may be building. Keep in mind that any indicator should be viewed more as a mile marker than a distance-to-destination sign.
Four examples of economic indicators that can warn of a recession include the yield curve, corporate profits, the unemployment rate and housing starts. Aggregated metrics, such as The Conference Board’s Leading Economic Index®, have also been consistently reliable over time. We’ll highlight one of the most well-known signals — the inverted yield curve.
An inverted yield curve may sound like an elaborate gymnastics routine, but it’s actually one of the most accurate and widely cited recession signals. The yield curve inverts when short-term rates are higher than long-term rates.
This market signal has preceded every U.S. recession over the past 50 years. Short-term rates typically rise during Fed tightening cycles. Long-term rates can fall when there is high demand for bonds. An inverted yield curve is a bearish signal, because it indicates that many investors are moving to the perceived safe haven of long-term government bonds rather than buying riskier assets.
In December 2018, the yield curve between two-year and five-year U.S. Treasury notes inverted for the first time since 2007. In late March, the curve between three-month and 10-year Treasuries also inverted. But other parts of the curve – such as the commonly referenced two-year/10-year yields – have not inverted thus far.
Even an inverted yield curve in that range is not cause for immediate panic, as there typically has been a significant lag (16 months on average) before the start of a recession.
6. How close are we to the next recession?
Economic indicators are a way to take the temperature of the U.S. economy. One or two negative readings could be meaningless. But when several key indicators start flashing red for a sustained period, the picture becomes clearer and far more significant. In our view, that time has not yet arrived.
Although some imbalances are developing, they don’t seem extreme enough to derail economic growth in the near term. The culprit that ultimately sinks the current expansion may one day be obvious: Rising interest rates, higher inflation, or unsustainable debt levels can be major triggers.
These events, if they continue, suggest that the economy could weaken in the next two years, placing a 2020 recession on the horizon. But we are not there yet.
The inherent difficulty in predicting the starting point of a recession shows why it’s usually unwise to make aggressive portfolio moves to try to time the market. The next recession will come eventually. According to our models, it could be in the next year or two. Regardless of when it begins, the best preparation is to ensure that your portfolio is well balanced and designed to meet your long-term financial objectives. Please reach out to your Investment Counselor if you any questions.
Jared Franz is an economist with 13 years of investment experience, four at Capital Group. Prior to joining Capital, Jared was head of international macroeconomic research at Hartford Investment Management Company and an economist at T. Rowe Price. He holds a PhD in economics from the University of Illinois and a bachelor's from Northwestern.
Darrell Spence is an economist and research director with 26 years of investment industry experience, all at Capital Group. He is a CFA charterholder and earned a bachelor's degree in economics from Occidental College.
Posted March 27, 2019.